Returns on an investment can be high. While each transaction has its own probability for success or failure, pros in this field try to average a 25 to 45 percent return on their money per year. There are home runs such as Sun Capital Partners receiving sixty-eight times its investment in a mattress retail chain, a transaction discussed in more detail later in this chapter. There are also many stories of small, local businesses purchased through the bankruptcy courts that succeed under new management. Some small companies do poorly, ending up in bankruptcy again. Be warned that even the pros can fail at buyouts, such as Cerberus Capital, a $27 billion private equity firm that specializes in investing in undervalued companies. Cerberus, named for the mythical three-headed dog that guards the gates of Hades, lost its entire multibillion dollar equity stake in Chrysler as part of the U.S. Treasury Department's bailout deal for Chrysler. Similarly, Texas Pacific Group and friends sank $7 billion into Washington Mutual in spring 2009. Only months later, the FDIC forced WaMu into a merger with JP Morgan Chase, losing the investment group over $5 billion on the deal.

Wanxiang American Corp., a subsidiary of a Chinese $4 billion auto parts company has purchased a number of underperforming companies. One of them was Rockford Powertrain, a maker of powertrain components for road graders, bulldozers, tractors, and other off-road heavy equipment. No surprise that they moved parts of the manufacturing to China, but about one-third of the U.S. jobs were saved. Design, quality, and supply chain problems were solved and the company was sold only a few years later for a 200 percent internal rate of return (IRR) for Wanxiang.

Another reason is to find a strategic fit with your existing business, which could be for a product extension or additional distribution. The French gaming company, Infogrames, made a successful tender offer for debt-swamped Atari in 2009. They were able to increase their game portfolio somewhat, but more important, they acquired (inherited?) Atari's game distribution contracts with thousands of retail outlets. New York Wire acquired Hanover Wire, both makers of co-axial cable and other wire products, to expand their product line and take over a company that was lowering prices in the market.

Defensive moves can drive acquisitions of troubled companies such as when Aleris tried to buy a smaller competing aluminum producer from a bankruptcy sale process. They wanted that plant dismantled and used for parts, taking the capacity out of the market place. Alcoa outbid them by a substantial margin and did the same thing, effectively taking overcapacity out of the market just as Aleris wanted.

If you have a customer in trouble, your own company may be at risk due to lost business. One could purchase a controlling position by trading money owed for a secured loan (being careful to avoid preferences or fraudulent conveyance) or give them additional capital in return for a controlling position.

A supplier in trouble could cause serious problems to a company's supply chain. A power company in Texas bought the short line railroad that delivered its coal when the railroad was headed for the bankruptcy court. There are many examples of a manufacturer buying a troubled component maker to protect their sources of supply.

Investors pursuing an active investment strategy generally follow a six-step process:

In general, the process will entail a search for a company (or part of one) that has a core competency to grow; assets to support the core; adequate financing available, including working capital; a plan to turn the company around; and an exit strategy if appropriate. Finding a distressed company to acquire is in many ways similar to the search for a healthy company, with various sources of opportunities.

Intermediaries often advertise companies for sale, and it is a simple matter of reaching to join their distribution lists whenever they engage a new sell-side client. These intermediaries come in many forms, from solo proprietor business brokers representing hair salons and restaurants to global investment banks representing Fortune 100 conglomerates with all or part up for sale. Working with brokers and their twenty-first-century equivalents—Web sites such as www.bizbuysell.com, which lists thousands of small businesses for sale all over the country, and www.bizben.com, which lists mostly California businesses—offers the primary advantage of deal flow. They will typically represent many different businesses and can send information on a variety of opportunities to ensure that a prospective acquirer sees a broad array of deals.

The downside, of course, is that this deal flow is by definition being shopped to a vast universe of potential buyers in the hopes of creating a competitive auction that maximizes sale values. Although distressed situations slightly mitigate this risk, as there are fewer investors interested in struggling companies than there are in healthy ones, the fact that there are many potential buyers viewing the deal makes a true bargain basement price less likely.

Private equity funds therefore pride themselves on developing so-called "proprietary" deal flow, where transactions are not marketed so widely and there are fewer prospective buyers bidding on the sale. The various interrelated parties in distressed situations can provide such deal flow, and a shrewd buyer will attempt to engage with all of them.

Lenders can be a great source of potential acquisition opportunities, as they may be seeking to modify or exit their loans to struggling borrowers, who are likely to have tripped one or more of the covenants explained in Box 1 in the Introduction. If a borrower has taken write-downs of unsalable inventory or uncollectible accounts receivable—which often serve as the foundation upon which its borrowing base is calculated—a lender can find itself in a situation of overadvance, where it has extended more credit than its loan officers originally intended by the formulas in the loan documents. At that point, the lender often approaches the equity holders, frequently the management team in lower middle market or family-held businesses, and requests that they make an equity infusion to address the overadvance. Various factors may make such an infusion impossible. At that point, the lender may begin to put pressure on the management team to begin seeking a buyer.

From a buyer's perspective, a key transition occurs when the responsibility for a loan is transferred from the loan's originator to the bank's workout group, also commonly known as a SAG, or special assets group. At this point, the bank has recognized that the borrower is in trouble, and repayment is in doubt, so it transfers the loan from the originator's balance sheet to that of the workout group, which specializes in maximizing recovery from troubled loans. This creates two key benefits for potential buyers: first, the workout group is accustomed to distressed situations, and is therefore less likely to suffer from paralysis as the loan originator, who may feel the same temptation felt by management to pretend that the problems are temporary and act as if the loan will be repaid. Second, the transfer of the loan to the workout group is often—but not always—done in conjunction with some write-down of the loan's expected value. For example, an originator might have carried the loan on her balance sheet at $10 million (the amount extended to the borrower), but the workout group may receive it on its balance sheet already written down 20 percent to just $8 million. The combination of these two effects—a comfort with distressed situations and a lower hurdle rate for success—tends to make workout groups more likely to force a sale (or other transaction) in order to speed the bank's recovery, unburdened by the fear that the originator might feel of recognizing that the loan was a mistake. The workout departments of lenders are often the best business minds in the institutions, but are also the toughest negotiators with recalcitrant borrowers.

With time, a buyer can develop relationships with such workout groups, and become one of the first people they call when they believe that they need to force a sale. The advantage to such sources of opportunities is that they may offer truly proprietary deal flow and an opportunity to work with a company long before a bankruptcy filing is necessary; the disadvantage is the difficulty of establishing such relationships without a past track record of working with the workout group. They must believe that you have the resources to close on a transaction fairly quickly. Once in a while, banks will foreclose on a borrower and "toss the keys" to someone like you. This will only happen if you can convince them you bring industry or other turnaround expertise—and you will keep a significant part of their debt on the books, even if converted to non-recourse debt if possible.

PACER, or Public Access to Court Electronic Records, is a good source for any bankruptcy filings, which are a matter of public record. Located at www.pacer.gov, the PACER system will contain the initial filing and then various highly detailed schedules of every bankruptcy filing in the United States, searchable at $0.08 per page. PACER is inexpensive, exceptionally thorough, and contains companies who have already reached a stage where they are likely to be receptive to purchase offers, but it has the disadvantage that as a public document, any opportunities it contains will probably have been seen by many other potential purchasers. This is also where you could learn of parts of a company you could buy.

Attorneys can occasionally represent good sources of deal flow, particularly those who focus on bankruptcies, restructuring, and insolvency. As mentioned above, any bankruptcy will be a matter of public record. Attorneys who work with troubled companies are sometimes hired well before a filing becomes necessary, and so they may be able to make introductions to potential buyers while the troubled company still has enough breathing room to review its strategic alternatives. Note, however, that such introductions are outside the typical restructuring attorney's job description, and unlike investment bankers and brokers (who get paid a success fee upon the closing of any transaction), attorneys will not have the same financial incentive to consummate a deal, and may even fear losing the client in the event of a change of control. With almost 10,000 businesses filing for bankruptcy each year, there are plenty of opportunities as well as traps. Attorneys in the field know each other and can help as sources of deals.

Turnaround consultants can become a source of investment opportunities for interested buyers, although a raft of tricky incentive problems may make them less practical as a reliable referral source. On the one hand, if a company hires a turnaround consultant, it has either been forced to by a fed-up lender or it has recognized its own distress; either way, it generally indicates a greater receptiveness to sale proposals. On the other hand, turnaround consultants may have limited incentive to refer the company to potential acquirers, instead preferring to attempt the turnaround on their own. This can create an adverse selection problem; if a turnaround consultant who has been hired as a chief restructuring officer recommends that management sell the company, she probably does not believe in the success of the turnaround, suggesting that the company is not a perfect acquisition opportunity. These consultants often work as receivers for companies going through an assignment for the benefit of creditors, the state law version of bankruptcy. These deals may be "shopped" less than bankruptcy.

10-K and 10-Qforms from public companies can suggest targets to buyers, as one of the most attractive opportunities can come in the form of neglected subsidiaries of larger public conglomerates, such as Middleby's 2001 acquisition of Blodgett from Maytag as discussed in Chapter Three. Often, trouble at the parent level can cause management distraction, driving a decision to exit struggling business lines at bargain prices. Alternatively, a subsidiary's struggles may stem directly from its inclusion under a larger corporate umbrella, either because the subsidiary is prevented from targeting certain customers due to a conflict of interest from the parent, or because it is forced to use the parent's product as an input when that input may not be competitive or cost effective.

News sources can unofficially signal a company's impending trouble, which could presage its becoming available for a distressed sale. Any time a newspaper reports a plant closing, a hiring freeze, mass layoffs, or the discontinuation of a product line, a shrewd observer can conclude that the company may be considering selling some or all of its assets. In the electronic age, one need not read dozens of newspapers, but can instead set up a focused set of daily searches on Google or other search engines, which deliver daily e-mail alerts anytime phrases such as "plant closing" or "as a going concern" appear in a major news bulletin.

In the past decade, news services have even emerged with a specialized focus on the distressed world, such as Beard Publications and its Troubled Company Reporter. Recently, another company called Indicium Solutions has begun offering a subscription service that delivers daily batches of leads on potentially distressed companies. Indicium's proprietary software tool scrapes the pages of every state and federal courthouse in the United States, identifying situations where a company has become delinquent in paying its taxes, has been sued for nonpayment of an outstanding debt, or has had a judgment issued against it by a court, all of which are early-stage indicators of distress.

Wealth management firms are a good source for family-owned firms that may have problems. Sale of the company may be the only way to satisfy unhappy heirs. Family offices are a similar source if you can get an introduction.

Finally, professional networks can produce serendipitous introductions to companies whose distress has yet to become public knowledge. Frequently in my career, I have been approached by an acquaintance, colleague, or former student, asking a question about the bankruptcy process, or what they should do regarding a customer who has begun stretching out payments. It's impossible to tell from where the next opportunity might come, but it always helps to keep one's ear to the ground. For more targeted networking, I have found my membership in (and occasional leadership of) the Turnaround Management Association invaluable, as it surrounds a turnaround practitioner with all of the various turnaround stakeholders in a professional setting. Other relevant professional organizations include the Association of Insolvency and Restructuring Advisors and the American Bankruptcy Institute, each with its own niche focus within the larger turnaround world. Your own network of friends may yield a conversation of employers having problems with an underperforming subsidiary or division.

In assessing a distressed acquisition target, an acquirer must go through precisely the same steps outlined at the beginning chapters of this book. The first step is to identify both the external and internal causes of the company's distress; each cause presents a different level of risk going forward, some of which can be mitigated, and others which cannot.

Generally speaking, external forces will be more difficult to change, and therefore a company struggling with external causes of distress will—all else being equal—present a less attractive turnaround candidate for an active investor. For example, most if not all distressed companies will blame some sort of economic downturn for their struggles, particularly in any recessionary environment. However, shrewd investors are highly reluctant to bet on a company's recovery based entirely on taking advantage of a cyclical recovery, for downturns can and have lasted far longer than the investor's ability to fund working capital during a period of sustained losses. If a recovery is included as a key assumption in the acquirer's turnaround plan, however, it should be highly conservative, such as when HIG Capital invested in troubled homebuilder Coachmen Industries in late 2009, when the collapse of the housing industry had forced dozens of other home-builders into bankruptcy filings.^[185] An HIG representative later explained their willingness to invest in such a downtrodden industry because their analysis suggested that Coachmen would not require a return to the housing boom of 2005-2007, but rather just a return to a historically low level of homebuilding activity.

Similarly, industrywide issues can be so profound that they make an investment in the space out of the question for most distressed investors. The question is one of permanence: Will the issue resolve itself naturally, or does it represent a permanent drag on the profitability of companies in the industry? For example, Walmart's stranglehold on the American retail supply chain may wax and wane over time, but for the purposes of anyone considering acquiring a vendor selling to the gargantuan retailer, it has to be taken as a given for the indefinite future. But sugar growers in Brazil had no less viable a business in 1999 simply because a statistically foreseeable drought had plunged many of them into bankruptcy; even a merely bad season of weather in 2000 would return them at least to break-even. Government regulation that has directly or indirectly caused distress also falls into this category, although the slow pace of legislative change means that it will probably fall to the more permanent end of the spectrum. In both cases, however, a buyer must determine which issues can be expected to change, and which will remain a cause of distress for the foreseeable future.

Other external causes present a different question; rather than asking whether the external environment will remain the same, the buyer must determine whether the company can adapt (quickly and effectively) to this new environment. A company may find the ability to respond to changes in technology, such as in 1993, when IBM finally shed its mainframe mentality and embraced the client/server architecture. IBM could do this because its core competency lay not simply in that particular product, the mainframe computer, but in engineering effective solutions and marketing them on the strength of its historically pristine brand. Other companies may find that their core competence lies too far afield from this new change in technology, such as the carriage makers whose expertise in woodworking failed to translate to the construction of the newfangled automobile. (By contrast, the Studebaker Brothers Manufacturing Company was one company that had begun its life as a blacksmithing shop, giving it a core competency that allowed for a transition to automobile manufacturing so successful that it became the second-largest automaker in the world by 1913.)^[186]

Changes in business model and shifts in consumer demand present the same challenge to potential buyers of companies facing these external causes of distress. It remains to be seen whether newspapers can successfully translate their core competency as a trusted source of information into an online world with depressed advertising rates and customer reluctance to pay for content; it's hard to get the moth back into the cocoon. Investors in Krispy Kreme also had to evaluate whether low-carbohydrate diets were simply a fad that had depressed the donut maker's sales, or a wave that would leave the company as a niche provider with a mass-market cost structure. Schwinn actually presents a small success story in such a situation, but it took several owners to recognize how the brand could change to meet these changing consumer needs. After Sam Zell's group purchased the brand at bankruptcy auction and failed to turn it around, private equity fund Wind Point Partners acquired Schwinn as an add-on acquisition to an existing portfolio company called Pacific Cycle. Recognizing the brand's name recognition and its distribution agreements with large retailers such as Walmart, Wind Point acquired the company in a 363 bankruptcy sale. By leveraging Schwinn's distribution agreements, Pacific Cycle was able to address its significantly concentrated customer base, reducing Toys R Us from 90 percent of revenues to just 15 percent. This required a fundamental shift in the Schwinn business model, as it transitioned from being a bike manufacturer and marketer to essentially a licenser of its brand, with all of its production offshore. Wind Point ultimately sold the Pacific Cycle platform—which had also rolled up other distressed brands like Mongoose and GT Bicycles—for some fifteen times its investment.

Finally, a change in interest rates is one external change that can be fixed, although it may require tough negotiations with creditors with the extreme threat of a bankruptcy filing looming in the background. If the company is simply paying too high an interest rate on its floating rate debt, a renegotiation with creditors could address the problem, or a debt-for-equity swap in Chapter 11 reorganization could reduce that interest rate exposure.

In terms of internal causes, insufficient capital is perhaps the easiest one to address, as the rationale exists that a better capitalized company could fund the necessary capital expenditures and working capital needs to return to profitability. This can be tricky, however; many a reckless management team has bemoaned their simple need for additional working capital and short-term financing, when in fact their own leadership shortcomings have led the company to require capital infusions. A buyer who can identify a company that has genuinely struggled due to undercapitalization, however, has a relatively simple fix, with one caveat. While my colleague Professor Steve Rogers suggests that a buyer of a healthy company should reserve between 15–20 percent of the company's purchase price to fund working capital and any operational changes, savvy turnaround investors know that a distressed purchase will require a great deal more capital in reserve. The thirteen-week cash flow forecast, pushed out monthly for the rest of a year's period, should help determine how much is needed. The reason is that the depressed prices paid in distressed situations are just part of the capital need, because turnarounds always take longer and drain cash more than one can anticipate. In this way, they have many similarities to entrepreneurial startups (as discussed in the Introduction), which almost always require more time and capital than originally expected.

The blind pursuit of growth can also generally be addressed with a solid turnaround plan, as the buyer can restructure the organization by stripping out the business lines or assets that no longer support the company's revamped strategic focus. In the case of Flying J, the previous CEO's unchecked acquisition spree had led to the company owning two oil refineries and a 700-mile oil pipeline that any purchaser would be likely to divest in reorganizing the company. From the buyer's perspective, Flying J's decision to file for bankruptcy offered both advantages and disadvantages; the power of the bankruptcy court made it easier to strip out underperforming assets and created a streamlined process for the sale of assets free and clear of any liens, but the filing also meant that the company's availability had been publicized and there was a competitive bidding process. The company's advisors and its new CEO, Crystal Maggelet, did an outstanding job in negotiating deals that led to higher than expected selling prices for the cash-draining California refinery and the pipeline. In fact, one of the creditors offered to buy one oil and gas subsidiary for $30 million and was turned down. Thanks to an auction, it went for over $100 million.

Another example is Cannondale Bicycle, the leading producer of high-end bicycles, which in the late 1990s went into the motorsport business. These efforts at growth diverted management attention and created severe financial problems for the then public company. Pegasus Capital got involved prebankruptcy with loans in mid-2002. Cannondale went into Chapter 11 in January 2003 and Pegasus converted its loan and additional cash into ownership of the company. Pegasus recruited new senior management, who focused on the company's core bicycle business, selling off the motorsports group. They also worked on improving dealer relationships and supply chain efficiencies. With higher sales and profit margins, Pegasus sold Cannondale five years later for a large profit and won Buyouts Magazine's, "Turnaround of the Year" award for the transaction.

Bankruptcy also makes it easier to address the overextension of credit, as the purchaser can renegotiate with lenders or pursue debt-for-equity swaps as mentioned above. Product issues can present slightly trickier problems, as consumer perceptions of poor product quality or an antiquated brand tend to be sticky, making it more difficult to change them. However, as the successful turnarounds at Gucci and Harley-Davidson demonstrate, such efforts are not impossible. Any prospective buyer must first evaluate whether the product issues can be fixed as well as whether the customer can be convinced as such, and then finally, whether this transformation can occur within an affordable timeframe.

Lastly, fraud and dishonesty can create attractive buying opportunities for investors when they bring about a company's distress, but the buyer must make absolutely certain that she has made a clean sweep of any bad actors within the organization. Because suppliers, customers, and lenders are likely to feel hurt and act with suspicion toward the besmirched organization, any new buyer will need to enter the situation cognizant of that fact. The buyer's newness to the situation may offer a clean slate, but that slate has to stay spotless, as even the appearance of any impropriety will look like backsliding to fatigued stakeholders. As the experiences of both Brasil Telecom and Symbol Technology show, any ties to past malfeasance must be eliminated rapidly in order to preserve credibility and inspire new faith among surviving employees.

After analyzing the causes of the company's distress, the prospective buyer can then identify where the company lies on the organizational distress curve. As explained in Chapter One, the further a company has slid down the curve, the greater the effort required to enact a successful turnaround and the lower the likelihood of success. In the context of buying a company, this means that a company at the crisis phase should sell for a lower price—all else being equal—than a company in the faulty action phase, and buyers should target a higher expected internal rate of return (IRR) on the investment to account for this increased risk. Generally speaking, traditional private equity firms focusing on healthy companies target a minimum IRR of 20 to 25 percent. While no empirical data exist on the subject, those target IRRs should increase at each subsequent phase on the curve. Example target returns might be healthy/blinded ≈20–25 percent; inaction ≈25–30 percent; faulty action ≈30–35 percent; and crisis/bankruptcy ≈35 percent or more. Remember that these are averages. Because there will be full losses sometimes one must actually target a rate over double those stated when determining a reasonable upside to the transaction.

After identifying the company's stage on the organizational distress curve, a buyer should research the company's warning signs. This should not, however, be an entirely retrospective activity, as it will do little good to determine what incumbent management should have seen before experiencing the current level of distress. Rather, the warning sign analysis should be conducted as of the present date, in order to determine what potential threats loom for the company going forward. Trend analysis of profitability and asset management indicators, an industry and product analysis, and review of diagnostic prediction models such as the Z-score, DuPont, and SWOT analyses can help a prospective buyer decide whether a target company has bottomed out at the faulty action phase, or whether further degradation in its financial performance seems likely, bringing it to the crisis phase.

The last stage in assessing the opportunity is to use as much information as is available to construct a preliminary 13-Week Cash Flow Model in order to get a clear picture of the company's near-term liquidity needs. This can prove very difficult in distressed situations, especially when a disgruntled lender is forcing a transaction on management, who may rebel by attempting to withhold information or provide inaccurate records to potential buyers. One company had been cutting checks to pay vendors, reducing the accounts payable accordingly, and then the CEO would put the checks in his desk drawer because he knew they needed the cash for payroll. Even if numbers are given in good faith, it-difficult to get comfort in the accuracy of a troubled company's financial records. Typical adjustments that are used to recast a seller's income statement include

Many other changes may have been made as well. Of course, any of these should be adjusted back up by the buyer, who must demand full disclosure of all such recasting. These adjustments on the part of the seller are often more than offset by the costs that will be incurred by the new turnaround team, the hiring of competent managers, suppliers who want to make up for prior losses, the need for better advisors, and so on. In general, skepticism should reign, as inventory will often be burned through, working capital balances will have been overstated in order to increase the borrowing base, and cash balances will be inaccurate. As always, caveat emptor.

Pro formas purportedly showing future financial performance as improving on its own soon always makes me think the translation from the Latin pro forma means "if we are incredibly lucky" or "no-way, no-how." However, even with imperfect information, the 13WCFM is a crucial step, as it serves as the foundation for understanding how much excess capital will be needed to fund the turnaround process. As explained above, the purchase price of a distressed company can be as little as half of the total capital need.

All of these assessments of the company, its situation, its customers, its suppliers, its management, and its liquidity needs fall under the broad category of what M&A investment bankers and attorneys call "due diligence." The irony arises from the fact that due diligence takes on twice as much importance in a distressed situation, and yet must be conducted in less than half the time. This results in the paradoxical allure of buying distressed companies; it is a harrowing experience, fraught with unfathomable stress and anxiety and the constant risk of losing every penny of investment capital, and yet the stress junkies who are drawn to it consider it more addictive than any drug, and it can fill your wallet instead of emptying it.

The purchase price of an underperforming company is much more difficult to negotiate than for a normal company. The main reasons are that there are more stakeholders than usual involved in the negotiations, valuation is even less precise, and there are arguments over who should pay for the turnaround. The negotiations for the price per share of a normal company usually take place between the buyer and the owner or board of directors representing the owners. In the case of a troubled company, particularly one near the crisis stage, there could also be the banks and bondholders at the table. If the company is in bankruptcy, one can add the unpaid vendors, lessors, unions, the PBGC, the U.S. trustee, and the judge.

Valuations of troubled companies are always imprecise. Generally speaking, there are three ways to value a company: income-based approaches, market-based approaches, and asset-based approaches. Income-based valuation methods rely on the assumption that any asset is worth the future cash flows it will generate, which must be discounted back at an appropriate interest rate to reflect the time value of money. The discounted cash flow (DCF) model therefore requires assumptions regarding the timing and magnitude of a company's cash flows. A related, less complicated income-based approach would disregard the company as a going concern and instead forecast how long it would take and what value could be received in an orderly sale of all of the company's assets, whether business unit by business unit or in its entirety.

Market-based approaches compare the company for sale to related companies (typically those in the same industry, geography, and general size range) to determine the appropriate multiple to apply to some measure of the company's profitability, such as net income, cash flow, or EBITDA. For example, if ten generally similar public companies ("comparables" or "comps") are trading at an average of 7.5 times their last twelve months of EBITDA, one could argue that the company with $1 million in EBITDA over the same period is worth $7.5 million. A related approach uses recently announced M&A transactions to identify a similar multiple to apply to whatever metric of profitability has been selected. Naturally, these approaches can be garbage-in, garbage-out, as the selection of an overly friendly set of comparables, a timeframe that intentionally includes or excludes outlying transactions, and the measure of profitability selected can greatly influence one's conclusion on valuation. It goes almost without saying that a buyer should rely only on his own assumptions in using either such valuations, as sellers will invariably be overly optimistic regarding future projections, and will try to paint historical performance in as positive a light as possible; even in the absence of outright distortions and deception, sellers will often attempt to add back "one-time" expenses to produce a much healthier-looking "normalized EBITDA" or "normalized cash flow" when such expenses are in fact likely to recur. Buyers should therefore always value a company based on their own multiple of their own projections, rather than simply accepting the seller's proposed multiple of the seller's projections or claimed historical financials.

Both the income-based and market-based approaches encounter significant difficulties in their application to distressed companies. In the case of income methods, the selection of an appropriate discount rate is very challenging, because it must be significantly higher than its competitors to reflect the extreme riskiness of a company in distress. (Flip Huffard commented that in his opinion, the discount rates used in DCF models for distressed companies are chronically underestimated, and should approach 20 percent.)^[187] In the case of market-based approaches, it is fundamentally difficult to apply a multiple to a distressed company, because any measure of its profitability is so likely to be depressed that the multiple would be meaningless, or even negative.

The final type of valuation methodology is an asset-based approach, typically the liquidation value, or the amount that each individual asset of the company could fetch at a forced auction. Buyers would prefer to pay no more than liquidation value, because it limits their downside. That's literally the last thing anyone, other than maybe the senior bank, would want. That senior lender may already be playing hardball, restricting working capital borrowings, and forcing the payable to be stretched. These three types of valuation are summarized in Table 9.1.

Books and articles abound on these subjects, and should be consulted, along with an attorney who has negotiated distressed M&A deals and an investment banker if the size of the deal justifies it. (See Box 10 for more information on items that may affect the valuation of distressed companies.)

The biggest argument often centers around who will pay for the turnaround. The sellers will say, "This company can be returned to profitability again, so you have to pay extra for the potential." Your answer would have to be, "Then go ahead and do it yourself. If I am to take the risk of the turnaround, I cannot pay you for it." In the end, the price usually is negotiated somewhere closer to the current value.

The key is for you to determine what the company is worth to you, including what portion of what debt you'll assume, what working capital you want, and what liabilities, if any, will be assumed. Then, let the stakeholders sort out how they'll divide up the proceeds and the carcass. Remember that ultimately the price will also depend upon the structure of the deal.

It is possible to purchase a distressed company through several different structures and processes, each with its own advantages and disadvantages. The categories listed below are just typical examples, for each distressed acquisition has so many nuances that no two deals are exactly alike. In general, the bankruptcy process offers the most buyer protection from pre-sale claims, as a federal judge officially declares the termination of such claims in most bankruptcy-related transactions. However, this protection comes at the added expense of the bankruptcy process. All the other transactions fall further to the other side of the spectrum, where protection is limited but time to closing and transaction costs drop accordingly.

Sometimes buyers of distressed businesses are so focused on winning the deal that they are startled when they find they own it and now must laser in on managing the purchased company and enact a turnaround. The buyers should have already determined the core competency and the new strategy of the company, and are starting from behind if they haven't. The first critical step of managing a recently purchased distressed company is to ask the most difficult question a board or an owner ever faces: whether to retain the existing management, particularly the CEO. There will necessarily be many factors driving this decision; some may argue against "changing horses in the middle of a stream," suggesting that despite a few mistakes, the incumbent CEO knows the company and the industry better than any available replacement, for whom the learning curve would prove too steep in a time-sensitive environment. Others will recognize that the company's slide down the organizational distress curve happened under someone's watch, and that someone should likely be held accountable.

For me, this decision hit home when I learned (through an investment banker) of the opportunity to acquire a subsidiary of a public company, a plant in Alabama that made appliance and automotive parts. The parts that accounted for the most revenue were the "dashboards" or front control panels of washers and dryers, sold to almost every manufacturer. They were made by first stamping the forms out of coils of cold rolled steel, putting those through an anodizing bath, then silk screening the appropriate color and customer logo on each. The painted parts went by conveyor belt through ovens, to bake the paint into the shiny, enameled colors that will match the body of the washers and dryers. We were given access to the company's books and records and flew down for a plant tour. This company was making some money and running at full capacity. The parent company did not have the capital for expansion or to make changes that would lower their high internal scrap rates on the dashboards and on some of the auto parts. As part of my due diligence I informed the sellers that conversations with their largest customers were required. They agreed.

In a phone conversation, the head of purchasing for General Electric's Appliance Group stated, "If all my suppliers were like them, I'd be out of a job!" I immediately expressed my alarm about problems I'd missed. He laughed and said, "They are one of our only suppliers, out of 20,000, that my records show have never had a part rejected for failing a quality test. That's why they get most of our business for the dashboards as well as for our refrigerator and oven door handles. They say they don't have more capacity for other parts." Relieved, due diligence continued with an additional plant tour with an outside consultant who was an expert in manufacturing, meetings with management, deeper digging into their books, and reviewing contracts with customers, suppliers, and labor. After raising debt from banks to cover 50 percent of the purchase price and giving a minority position in the company to the seller to cover the rest, we closed the deal.

A plan was created with the current CEO of that unit for the needed strategic, operational, and financial changes. This was the executive described in the Introduction who split our agreed plan into two lists, those he couldn't do and those he didn't know how to do. Our team and a replacement CEO moved soon to implement the plans. As to strategy, the decision was made to eliminate the products made for the auto industry and focus on the company's core competency of appliance parts manufacturing. On the operating front, the first priority centered around the reason for the high scrap rate. Conversations with employees and plant visits showed that the inspectors, all women, were told "to examine the painted surfaces carefully and reject any that don't look perfect!" They used large mounted magnifying glasses to look for almost microscopic flaws and scrapped a significant number of parts. After conferring with the customers and testing inspectors' eyesight for normal reading power, the magnifying glasses were eliminated. If a defect couldn't be seen with the naked eye, even on close inspection, there was no rejection. Scrap rates dropped in half. New dies for the stamping machines dropped the scrap rates to almost zero.

As far as the rest of the manufacturing process was concerned, finding ways to give employees more authority to make changes in efficiency paid off as well, when they suggested how fewer people could be used to run various groups of machinery. The excess personnel were used to increase capacity for new appliance parts. The company's improved performance led to its sale a few years later to a strategic buyer for a 74 percent internal rate of return on the investment.

In my experience, the phase of distress at which the company finds itself on the curve is not a strong indicator as to whether replacing the CEO is the right move. Rather, it is a highly idiosyncratic process, wherein a rigorous management analysis of the type discussed in Chapter One is necessary to determine whether the incumbent has the tools necessary to lead a turnaround. Other factors include the structure that the transaction took; under a 363 sale, for example, it is possible to enact "key man" retention plans that could incentivize a skilled CEO to remain despite the washout of his or her previous equity holdings. (Winn-Dixie did precisely that in order to convince Peter Lynch to oversee the turnaround after the company filed for Chapter 11 protection.) The CEO may not even be willing to remain on the job, particularly in smaller family businesses where the transaction marks the end of the ability to treat the company like a piggy bank for rich perquisites.

Overall, the best indicator of whether a regime change is in order is a look back at the identified causes of distress. If a company truly has fallen victim to a perfect storm of economic downturn, rising input costs, and temporary overcapacity—as so many CEOs of troubled companies will invariably claim—then the existing team may well have the ability to turn the company around if they agree with the proposed strategy. Note that all of those causes can be classified as external ones. If, however, the major causes of distress are internal, such as the blind pursuit of growth or major product issues, that represents a strong indication that new management would be better suited to leading a turnaround. Obviously, any credible evidence of fraud or dishonesty in the executive suite—or even the tacit permission of it at lower levels, such as a laissez-faire attitude toward kickbacks or expense padding—should be considered a clear and unambiguous indication that anyone implicated needs to go. Turnarounds require a tight ship, with integrity and credibility above all else, and anyone involved in such misconduct cannot be allowed to taint the new turnaround effort.

Regardless of whether the CEO leading the turnaround is old or new, the management of an acquired distressed company follows precisely the same process as explained in Chapter Two, with a three-pronged approach to strategy, finance, and operations. The new owner will enjoy one advantage in this process in that his or her newness to the situation will make a true reengineering more easily attainable. He can analyze the business as a true outsider, lacking in preconceptions built up by years on the job, and start with a clean sheet of paper in determining exactly what is important to customers and what is not. Upon initiating the turnaround plan, the CEO must then keep a relentless focus upon the 13-Week Cash Flow Model, in order to monitor its effectiveness and prevent any backsliding into complacency after the quick initial gains from low-hanging fruit. In winning Buyouts Magazine's award for the 2008 turnaround of the year, $8 billion private equity firm Sun Capital, which has invested in 230 distressed companies, was cited for increasing retailer Mattress Firm's EBITDA twenty-two fold. The company was purchased from a grateful parent company, happy to get rid of its underperforming subsidiary. Sun paid $4.5 million in equity and added $30 million in debt. The unit owned 200 stores and had no idea how many potential customers came through its doors each day. Sun decided to keep the CEO, strategically decided to make the stores more homelike by installing wood floors and artwork on the walls, and became supercenters for mattresses. They were praised for operating changes such as closing unprofitable stores, opening others in growing markets, and upgrading their sales force. After changes in how working capital and inventories were handled, profits began to soar. Sun sold the company after four years of ownership for $450 million.

Strong leadership will prove critical throughout the process in order to unite an anxious stakeholder base. This leadership becomes particularly important when layoffs threaten to depress morale, for employees take their cues directly from senior executives during periods of adversity. Now, if you are scratching your head and muttering that these two paragraphs sound like a reiteration of all of the chapters of this book, you have not only been paying attention, but you are beginning to take an appropriately holistic view of the process of buying a distressed company. Once acquired, it is almost no different from any other turnaround, with the major difference stemming from the buyer's novelty to existing stakeholders, which both puts pressure on the buyer to develop credibility and provides a clean slate with respect to past mistakes or underperformance.

Executing a turnaround based on the "tripod" approach with a fundamental reengineering as its centerpiece sounds terribly complicated, but successful distressed investors know that the process is not, as they say, rocket science. The goal of increasing cash flow has several major levers; top-line revenue, gross margin, SG&A, and interest expense. The three-pronged turnaround approach can use various strategies to push those levers. Raising prices, niches for old products, and new product development can increase revenues; more intelligent input sourcing can expand gross margins; outsourcing nonessential functions can decrease SG&A; and better working capital management can reduce interest expense. The particular strategies themselves are tricky, particularly in a company swimming in reams and reams of complicated, sometimes conflicting data, but keeping those major levers in mind can help guide one through the forest. It has been chronicled how private equity players and other value builders move quickly to do extensive due diligence, then move again at surprising speed to put their plan into action.^[188] It helps that private equity players are just that—private. They don't have the pressure of a public company's quarterly earnings report, giving them (or you) the edge in building value, where the biggest failure will be the failure to act.^[189]

Upon successfully executing a turnaround and returning a company to health, the professional buyer will usually begin to contemplate an exit strategy. Three main opportunities exist: an IPO, a recapitalization, or a sale. IPOs, obviously, will only be available to larger companies, because the costs of being public are so prohibitive. Recapitalizations were a very popular method of increasing return for private equity firms during the credit boom, as they could simply pay off a company's debt (and hopefully increase its profitability) and then relever the company, taking the proceeds of the debt issuance as a special dividend to equity holders. So-called "dividend recaps" allowed PE firms to maintain their ownership of a company while taking a lot of money off the table and increasing their internal rate of return, which, as a time-weighted measure of profitability, benefits greatly from earlier returns of capital. However, the excesses of the 2002–2007 credit boom have left many lenders appropriately reluctant about extending debt financing for the purposes of a dividend recap, given how aggressively the concept was abused by some PE firms during the boom. (One lender tells a story, all too familiar to his peers, about an equity sponsor who paid off the debt of a portfolio company and took the maximum agreed-upon dividend recap of seven times EBITDA of $20 million for $140 million, then just one quarter later, when EBITDA had increased to $21 million, came back demanding another $7 million in debt financing to juice its IRR.) Although recapitalizations will be available to healthy companies, the "once bitten, twice shy" mentality of most lenders post credit-crunch will make them less realistic for companies whose past distress may make lenders gun-shy.

That leaves a sale of the company as the most realistic exit option. Stacks of books have been written on the mergers and acquisition process, so I need not go into excessive detail here about what it takes to sell a healthy company. However, the buyer of a distressed company will face one additional hurdle in attempting to exit after executing a turnaround. The very fact that the company was once distressed will deter many buyers, simply because it suggests the company is not infallible, is not recession-proof, is not operating in an industry with such attractive economics that it cannot encounter difficulties. To most rational human beings, it should be obvious that every company in the world fits that description, but many private equity buyers are under pressure from their investors to identify companies that cannot possibly miss. Taking that into account, a buyer of a distressed company must therefore provide a credible explanation as to why the company's past distress will not recur in the future. The causes of distress identified in the assessment process will help here, as it is far easier to convince a potential buyer that internal causes (now addressed by the turnaround) led to distress, rather than external causes that could arise again.

In addressing these concerns, buyers will often look to the holding period to determine the seriousness of the risk of repeated distress. An investor who has bought a distressed company and is attempting to sell it just twelve months later will find buyers a great deal more hesitant than one who bought a company four years ago and has seen three steady years of profitability. This can naturally extend holding periods for distressed investors, which compresses IRRs, but one hopes that the depressed purchase price at acquisition more than compensates for that irregularity. Sale to a strategic buyer usually yields the highest sale price.